Stocks Research Paper

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Stocks are a type of financial instrument that represent ownership in a business organization. Ideally, the price of any stock is equal to the present value of expected future cash payments to the stockholder. Stocks perform specific and important functions in financial markets and in the economy generally. From the perspective of private investors stocks are a form of financial investment. Ownership of stock in a business entitles a person to part of the profits generated by the operation of that business. When a corporation realizes profits, it pays a dividend to its stockholders, though it will often retain some profits to finance additional business operations.

Stocks differ from other financial instruments mainly in terms of risk. For example, bond owners are paid interest according to their bond’s annual yield. Companies that issue bonds enter into a contract with bondholders to pay a specific amount of money over a specific time period. Once a bond matures, the company that issued the bond returns the money that it borrowed to the bondholders. Stockholders, in contrast, are the owners of that company. Since corporations are legally obligated to pay bondholders interest, bondholders risk default if the issuing company goes bankrupt. Since the dividend paid by the company varies with the performance of that company, stockholders can realize a poor rate of return without the company actually going bankrupt.

Economists view stocks as a particular type of institution that performs specific social functions. Stocks, and other financial instruments, play an important role in the functioning of capitalist societies. Stocks, bonds, and other types of loans are alternative means of financing the operations of a business. Stocks represent a means of raising financial capital for business investment. Anytime a business sells new shares of stock, the investors who buy them provide funding for new entrepreneurial business projects. Investors who buy new shares of stock in a company are speculating about the future profits of that company. If the projects that a company undertakes realize or exceed expected profits, its stockholders (unlike bondholders) will earn high dividends and capital gains. So the capitalists who buy shares of stock are speculators who attempt to predict future trends in the economy. Efficient businesses produce products that consumers want most urgently at a low cost. Efficient businesses will earn the most profits for their stockholders.

Capitalists who speculate accurately concerning different businesses can earn new fortunes for themselves by providing finance to efficient businesses. Capitalists who err in predicting future economic trends can lose previously accumulated fortunes. In this way stock ownership can work as a regulating mechanism to direct money into efficient businesses that need additional funding to expand and away from inefficient businesses whose operations should be curtailed.

Most stock trading involves previously owned shares of stock rather than newly issued shares. Trading of existing shares of stock is also important to the functioning of businesses. The price of existing shares of stock tells a company how much money it can raise by issuing new shares. Of course, businesses need not use this method of finance, and many businesses buy up existing shares of stock to increase the value of the remaining shares. Yet stock ownership still affects the business’s performance.

It is important to note that stock ownership implies a separation of ownership and control. Stockholders own a corporation, but the chief executive officer (CEO) or president actually manages the daily operations and plans the future operations of any corporation. Separation of ownership and control in a corporation, though, poses a potential problem. The CEO and other top executives may abuse their authority at the expense of stockholders. Both bondholders and stockholders have an interest in the efficient operation of the corporation in which they have invested. Under specific circumstances, bonds and stocks are virtually identical. If investors have perfect information on the activities of corporate officers, if taxes affect bonds and stocks equally, and if the costs of transacting for stocks and bonds are equal, then stocks and bonds will be perfect substitutes as far as investors are concerned. The logic behind this proposition is simple. If people have perfect information about the activities of corporate officers, then they will know exactly what the future stream of dividends will be. If a stock will pay more than a bond with certainty, then investors will buy more of that stock. When investors own more shares of a stock, its price will rise, and its dividend will fall. The rate of return of a stock will therefore be equal to the interest rate on bonds—if investors have perfect information on the operation of that corporation by its top executive officers. Investors might prefer stocks or bonds for tax reasons or because of differences in transactions costs. But given our three assumptions, bonds and stocks will appear identical to investors.

The idea that investors have perfect information is completely unrealistic, but it does tell us much about the real world. Stocks are different from bonds because of the differences in information needed to profit from these two types of investments. All bondholders need to know is that corporate officers are doing their jobs well enough so that the corporation can avoid bankruptcy and pay interest on its bonds. With stockholders things are different. Every penny that the corporate officers waste or take for themselves is money lost to the stockholders. Consequently, stockholders need to be much better informed about the activities of corporate officers than do bondholders. Bonds are a good investment for people who want a decent rate of return without much bother. Stocks can deliver a higher rate of return but require more attention from investors. Consequently, owners of stocks act as corporate watchdogs to make sure that corporations run efficiently. Of course, some stockholders fail to pay proper attention to their corporate officers. But many stockholders do pressure corporate executives to run their businesses more efficiently, and this pressure contributes to the overall efficiency of the economy.


  1. Jensen, Michael, and William Meckling. 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics 11: 5–50.
  2. Miller, Merton. 1977. Debt and Taxes. Journal of Finance 32:261–275.
  3. Modigliani, Franco, and Merton Miller. 1958. The Cost of Capital, Corporation Finance and the Theory of Investment American Economic Review 48 (3): 261–297.

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